Equity returns since October have been largely driven by macroeconomic factors — like central bank policy and the effects of rising trade tensions — in a sharp reversal from the third quarter of 2018, when stock-specific news dominated changes in equity prices, according to a new research published by Goldman Sachs.

“A number of metrics reflect a macro-driven environment,” wrote Goldman analysts, led by Ryan Hammond. “Average three-month stock correlations surged from a near record low in October to the 94th percentile today. The spike in correlations was the fourth largest on record, behind only 1987, 2011 and early 2018,” they wrote.

30% of the typical stock’s performance can be explained by movements in the broader market, on average, according to Goldman, but that has risen to nearly 60%, as of Feb. 11.

When macroeconomic factors dominate investor decision-making, they result in asset prices moving in tandem, because these factors affect asset prices equally. For instance, the Federal Reserve’s recent pivot toward a wait-and-see approach to raising interest rates has made equities a more appealing investment overall, relative to other assets like bonds.

An environment of high stock correlations, where assets and sectors tend to move in tandem, tend to be tough for active money managers to thrive, because it diminishes the rewards of selecting individual assets if they rise and fall in lockstep. Goldman analysts predict, however, that this latest bout of high-correlation moves won’t last.

“We forecast a stable macro environment in the near term, characterized by steady U.S. economic activity and a patient Fed, which we believe has been priced in the market,” Hammond wrote, adding that given the nearly 10% advance staged by the S&P 500
SPX, +0.14%
year to date, U.S. stocks’ rise will be much more subdued for the remainder of the year, creating an environment that requires active stock selection to realize high returns.

The report makes the case that changes in Federal Reserve policy and communication have been a central driver of the recent stock-market rally, but that the effects of this change have been largely digested by the market, reducing the effect macro factors will have on the market in the coming months.

Hammond points to evidence of a rotation into stock-picking strategies, as passive exchange-traded funds saw $32 billion in outflows in January, compared with $8 billion in inflows for actively-managed mutual funds, bucking the trend in recent years whereby investors have increasingly relied on passive instruments.

At the same time, Hammond wrote, such funds flowing into active strategies and away from passive ones is also “consistent with the pattern following historical S&P 500 drawdowns,” and may therefore not be evidence of new, sustained investor interest in stock picking.

Passive investing is typically defined by the use of low-cost exchange-traded funds or other instruments that seek to track the performance of a predetermined basket of stocks, like the S&P 500. Active investing is typically more costly, as investors must pay fees to the managers of active funds, who use fundamental research or other time-intensive strategies for picking stocks they hope will outperform the broader market.

Eric Wiegand, senior portfolio manager at US Bank Wealth Management, told MarketWatch that there may be more to the recent spike in correlation besides the immediacy of macroeconomic factors of late, with the broad trend toward passive investing likely being an important factor. “I don’t have any means of quantifying it, but logically, it would follow suit” that a larger share of investor money being passively managed would lead to higher levels of stock-market correlation.

Indeed, 2018 was a banner year for passive strategies, as it was the first year on record that the share of funds held in passive, large-cap equity funds surpassed the shares held by large-cap asset funds, according to data from Morningstar. Economists and investors have long theorized that this trend would lead to returns between securities becoming more correlated.

Wiegand points to December’s dramatic drawdown followed by this year’s sustained rally as evidence of herd behavior, driven by investor frustration with actively managed products. Just 38% of active U.S. stock funds survived and outperformed their average passive peer in 2018, according to Morningstar, down from 46% in 2017. “There’s been such a proliferation of passive vehicles, that it’s easy to point to them as the culprit,” he said.

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